IT’S shaping up to be an ugly day for European markets, which is making for an ugly day for American markets. The big European indexes were off 2% to 3% on the day, and the euro fell to its lowest level against the dollar in over a year. The decline is likely related to renewed increases in yields on government debt across southern Europe. These had fallen from recent highs in the wake of the weekend announcement of a €110 billion package for Greece. But for the moment, it appears that European leaders and the IMF have not sufficiently ring-fenced the Greece crisis. Contagion looms.

It’s surely not helping matters that rumours are circulating that Spain will soon ask for €280 billion in aid. Spain’s prime minister said the rumour was unfounded, calling it “madness”, and I believe him. But the nature of contagion is that people act on the rumour and ignore everything else. Back in 2008, markets attacked financial firms indiscriminately, even as bank executives pleaded that their finances were sound. They were, in some cases, quite right. But liquidity crises, if left unchecked, become insolvency crises. The panic becomes self-fulfilling.

It may be that European leaders have insufficiently demonstrated their awareness of the difference in the two kinds of crises. Aid to Greece has been generous, but it’s not clear that it will address the underlying insolvency of the Greek government. Forbearance worked in the case of the American financial system because banks could borrow cheaply from the government and then lend at a higher rate, thereby slowly recapitalising themselves. The 5% interest rate Greece is getting from Europe and the IMF is much lower than market rates, but it’s higher than Greece’s expected growth rate. The aid strategy has bought time, but it won’t save Greece unless growth surprises strongly to the upside.

Obviously, Portugal and Greece (aka Bear Stearns) are sideshows to the much larger Spain (aka Lehman). I’ll save a crisis in the UK or Japan for Fannie, Freddie.

Together the former two are not even 5% of eurozone GDP, whereas the latter is the 4th largest member and about 11% of GDP, I believe. Truth be told, while Spain’s economy is horrid (20% unemployment, i.e. they have honest government reporting, an American style credit bust as “financial innovation” went wild, without the ability to print money at will to make it all “go away”) its balance sheet is not nearly as horrid as Greece’s (or ironically, America’s!). [Feb 5, 2010: Sovereign Risk Chart – Where Would the US Fit in, on Europe’s Scale?] But again, printing money from thin air is a wonderful way to do partial defaults… the US, UK, and Japan are doing that. Spain cannot. Which makes me wonder if before all this is over the European Central Bank will get new powers that mimic the Fed because having your central banker print like mad and take government debt onto its balance sheet seems to be the only real solution in a world intent on kicking the can down the road.

The main news over the past 24 hours is that ECB has suspended the minimum credit rating requirements for Greek bonds – and only for Greek bonds – as collateral for its liquidity operations. It’s a decision without precedent. It effectively makes rating agencies irrelevant for the eligibility to central bank money, at least for Greece. This is a huge and embarrassing U-turn for Jean Claude Trichet, who had earlier stated that no exceptions would be allowed. But needs must. The move fuelled speculation that the central bank may have to extend that to other countries, renew a program of lending unlimited cash to banks for a year, and even start buying government debt if the €110bn bailout plan for Greece fails to stem the euro’s slide. While the ECB is prohibited from buying assets directly from authorities, it can buy them on the secondary market.

In a thundering editorial, FT Deutschland called the decision a communication disaster in the making. First, the ECB announced a return to the previous regime by next year, then comes the decision to reduce the minimum collateral requirement to BBB, and now the exemption for Greece only. What will the ECB do if (or rather when) Portugal’s debt go down? It concludes that the ECB must urgently revise the collateral requirements, and develop its own system.

Jean Quatremer makes the point that the ECB now faces the dilemma of having to explain why default is not option, yet lower the rating threshold to below junk status. He said the only logical outcome of this would be a general abandonment of the ratings system.

Mohamed El-Erian of PIMCO fame summarizes the bearish view on Greece and on why the saga isn’t over with the bailout announcement. Briefly the four risks he talks about – 1. Lending rates are not low enough 2. Greek GDP may contract more than expected 3. Large debt overhang to be a drag on investment 4. Existing holders of debt will continue to sell. In addition, Greece may lose its appetite for austerity and legal hurdles to aid disbursement remain.

To say the markets’ reaction to the packing is lackluster with a number of wild rumors causing concern and caution by investors who have been badly burned before on false dawns. Market participants are talking about newswire reports which say Greece has hired storied investment bank Lazard (LAZ) for advice on debt restructuring. As scary as this sounds, and if this were the entire story it would be rather apocalyptic for peripheral markets and the euro itself, there are some big holes in the story to note. First off is the dated nature of the story at April 30. More important, however, is the much more benign, and much more likely, explanation that Lazard has presumably been hired for advice on privatizing state assets and other ways of helping Greece reduce its bloated fiscal budget.

In reality, Greece is insolvent, a point that Professor Nouriel Roubini has recently elaborated on, with a warning that a bailout that does not recognize that the nation is bankrupt will waste an enormous amount of public money. Even more surreal, the very nations being asked to bailout Greece are themselves in deficit, in some cases having a national debt and yearly deficit to GDP ratio as bad as that which brought down Greece’s public finances. Several of the countries that will be contributing public money to prop up Greece are on everyone’s hit list of the next Eurozone nations to be the target of the unfolding sovereign debt crisis and bond vigilantes. These include Portugal, Spain, Ireland and Italy. We may soon witness the absurdity of nations that are experiencing their own debt crisis but must borrow additional money to bailout Greece, only to soon be in the same predicament as Athens, joining Greece in begging the IMF and their fellow Europeans to grant them a bailout.

Throughout the unfolding Greek debt crisis, politicians in Europe have sought to pretend that the problem was only one of jittery markets, and things would return to normal. Before pleading for a financial lifeline of $146 billion from the IMF and Eurozone, Greek Prime Minister Papandreou gave numerous assurances that his country would not need a bailout. Now we are being told that countries that are themselves suffering various levels of debt problems should add the massive costs of a Greek bailout to their sovereign credit cards, and somehow this will all work out.

I just don’t see the logic of asking a terminally ill patient to provide a blood transfusion to a corpse.

Observers like Charles Wyplosz, who point out that the adjustment being demanded of Greece is extraordinary and hard to see happening, are right. And yet .. one thing I haven’t seen pointed out sufficiently is that a debt restructuring, or even a complete cessation of debt service, wouldn’t do all that much to ease the burden.

Consider what Greece would get if it simply stopped paying any interest or principal on its debt. All it would have to do then is run a zero primary deficit — taking in as much in taxes as it spends on things other than interest on its debt. But here’s the thing: Greece is currently running a huge primary deficit — 8.5 percent of GDP in 2009. So even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity.

It follows, then, that a debt restructuring wouldn’t help all that much — not unless you believe that getting forgiveness on much of Greece’s existing debt would make it possible to take on substantial new debt, which doesn’t seem very likely.

The point is that the only way to seriously reduce Greek pain would be to find a way to limit the costs of fiscal austerity to the Greek economy. And debt restructuring wouldn’t do that.

Devaluation would, if you could pull it off. I see that Vox has reposted the classic Eichengreen paper on why you can’t. I’ve already written that this argument, which I found extremely persuasive when first made, now seems to me less than watertight. But let me be a little more specific.

The way things are going, it looks quite possible that Greece will spiral into domestic as well as debt crisis, and be forced to take emergency measures. And that makes me think of Argentina in 2001. At the time, Argentina had the convertibility law, supposedly permanently pegging the peso to the dollar — and that was supposed to be irreversible for the same reasons the euro is supposed to be irreversible now. Namely, to repeal the law would require extensive legislative discussion, and any such discussion would set off destructive bank runs, hence there was no way to undo the fixed exchange rate.